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Fixed income

Let macro set you free

For years markets have been operating under a benign form of bondage to central bank policy and technical factors.

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For years markets have been operating under a benign form of bondage to central bank policy and technical factors. The radical change underway in the investment environment suggests markets are finally wriggling free of these shackles.

We expect macroeconomics to reassert itself as the primary driver of much investor behaviour, as shifts in the global economy, politics and monetary policy are likely to sway assets in vastly different ways from those seen in the last few years.

Economic growth, inflation and interest rates may all be higher in 2017 than in 2016, although the extent and longevity of these moves depend on whether wages and productivity can gain positive traction after years of disappointment.

More significantly, the ‘grab for yield’ – driven by the relentless easing of monetary policy – appears to be over; higher volatility, shifting cross-asset correlations and plenty of political ticker ‘tape bombs’ are to be expected. In short, the dramatic shift in the investment environment is likely to disturb the technical backdrop and trigger aggressive shifts in prices.

THE WRONG MAP

Considerable pressure will probably be placed on investment strategies that have dominated markets since the financial crisis of 2008, primarily long carry, and the dominance of long-term mutual funds and exchange traded funds. Optimising strategies – risk parity, for example – will likely encounter problems when relationships between assets change.

Economic models designed for the post- crisis world will become less useful, in our view. Indeed, as economist Paul Krugman has stated, ‘[models are] sketch maps of the territory, and that you always have to consider the possibility that the map is all wrong — which means that you need to supplement technical training with history, psychology, and just plain looking out there at the real world.’

The map is often wrong. It can be spectacularly wrong at major historical transition points – and, I believe, we are now at such a point, which is to be expected at this stage of the geopolitical cycle. When the rule of one leading power comes to an end, barriers tend to go up, trade shrinks, nationalism revives and the chance of conflict increases.

The rise of US President Donald Trump is a symptom of this transition, not its cause. Because the trend is likely to persist, the move away from centre-ground politics towards populism will probably have huge consequences for macroeconomic fundamentals.

INGRAINED GROWTH

It is important to remember that global growth and inflation were already heating up prior to the US election. Since then, economic data suggest the upswing has become even more ingrained.

The US is close to full employment, so strength in earnings is likely to be a key determinant for the tightening of monetary policy and durability of the economic cycle. As for Europe, much of the growth over the last couple of years was due to higher real incomes, as inflation fell. With disinflation going into reverse, the reaction from wages will be crucial to the continuation of the recovery.

Any traction on wages, or indeed corporate investment – which has also been persistently weak – would be a serious change for markets and represent a significant boost to the world’s economic fundamentals. Global bond prices would be at risk, making tactical duration management key to preventing losses.

With the potential for higher rates on cash, as well as higher longer-term interest rates, a blanket of liquidity will no longer hide weak borrowers in the fixed-income market; therefore, much care is needed in selecting holdings.

NEAR-TERM JITTERS

The move to a new post-crisis footing is unlikely to occur in a straight line. In the short term, there are risks as investors tire of waiting for sustainable ‘reflation,’ US fiscal stimulus and tighter global monetary policy. Investing tactically has become particularly important given swift changes in sentiment, positioning and capital flows.

Moreover, there have been negative developments in the world’s three largest economic areas. The Trump administration has disappointed growth bulls, in light of its focus on curbing immigration and getting appointments approved – all the while mired in controversy over its stance on Russia – rather than seeking to pass an expansionary, deficit-increasing budget.

European politics has also begun to influence asset prices again, as investors fret most of all about the elections in Italy in 2018 and ponder the possibility of Marine Le Pen pulling off a surprise victory in the forthcoming presidential run-off against Emmanuel Macron. In China, meanwhile, economic activity has been strong but largely driven by credit, making it unsustainable in the longer term.

Nonetheless, we expect markets to continue adjusting to the new reality over the coming months and years. While freedom from the protective yoke of central bank support may be disruptive – and even unnerving – it also provides ample opportunities for investors who welcome this newfound liberty.

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